Overlooked Investing Basics

On a more positive note, think about what the business is giving back to you as an owner. Does the company pay dividends? Does the company buy back shares? These frequently overlooked investment basics are two great ways to reward owners, as dividends are actual cash payments to the owners, and share buybacks help make your block of shares a bigger percentage of the pie (in contrast to making your share worthless by continually handing out more pieces of the company). Remember, there is only so much to go around.

Thinking about expensive stock

Berkshire Hathaway, Warren Buffet’s company, is worth about $110,000 per share — a price tag that may scare you away from investing. A common misconception is that to find success in investing, you have to find stocks that are cheap (from a few dollars to a few cents). Sure, if you only have $1,000, you can not buy a share of Berkshire. You could, however, buy 100,000 shares of a stock trading at $0.01, but what are you really buying with that $1,000? How much of the pie are you getting with that stash?

Consider the company's number of shares outstanding — the total number of pieces the company is broken up into, minus the treasury stock — and figure out the percentage of the pie you own. Furthermore, it is important to understand how that price per share, no matter how high or low, relates to the key indicators of a company’s health, such as money in the bank, cash flow, earnings, and book value.

Take book value, also called shareholders’ equity, of a company, which is the difference between assets and liabilities. On the stock market, companies often trade above their book value, which is an indicator of the base worth of a company in the event of a bankruptcy. Without simplifying too much, if you really wanted a TV that was worth $1,000, would you rather pay $2,500 or $10,000, which are 2.5 and 10 times the book value, respectively? The answer should be obvious.

Of course, companies that are more exciting or growing faster, tend to have higher multiples because people are willing to pay more for something that is newer and more exciting. Keep in mind that some companies have negative book value, which means it has more debt than assets. Price-Earnings ratio (P/E) is also a common indicator. Basically, a P/E of 30 means that you are paying $30 for every $1 the company earns, and it would take 30 years to get your money back. Imagine P/E’s of 100 or 10, and think about where the best place may be to put your dollar.

The above illustrates an often-overlooked investing basic: The actual price of a stock is far less important than things like what the company makes on a per-share basis. So, when you see a stock that has a high price tag, it may be a better deal than a company trading for pennies.

Know your place

The stock market is often referred to as a living, breathing organism. There is some truth to that as it is reflective of the buying and selling habits of millions of investors, mutual funds, pension funds, money managers, and traders. The market is there to help find a balance between buyers and sellers, and that balance ensures that stocks are priced right where they need to be at a certain point in time.